Karachi bourse records boost investment interest

A Black Swan, as conceived by former wall street stalwart Nassim Nicholas Taleb, is an improbable event that results in extraordinary consequences. October 19, 1987 was a Black Swan event. The Dow shed more than a fifth of its value in a single day, now known as Black Monday. Black Swans are kryptonite for conventional investment portfolios where risk and return are assumed along a bell-curve shaped distribution around a mathematical mean. Taleb suggested a “barbell” shaped strategy.

His focus lay on the “tails”; the statistical outliers whereby a portfolio is largely allocated toward extremely risky or riskless assets, achieving balance and reducing exposure to Black Swans. This strategy is well suited to frontier markets, where equities tend to fit the criteria for the risky portion of a portfolio that may hit a Black Swan home run.

Impressive returns

It could be inferred that a Black Swan recently reared its head at the Karachi Stock Exchange (KSE) — in a city often dubbed the most dangerous on the planet. Pakistan enjoyed its first democratic transition in history in May, and watched a pro-business prime minister assume office. The KSE is up 40 per cent so far this year, putting it on course to be the world’s top performer in 2013. The KSE100, an index of the 100 largest companies by market capitalisation, hit an all-time high in July this year. Total market capitalisation hit $53 billion (Dh195 billion), up from $35 billion two years earlier.

This is not the first time such extraordinary returns have been registered. In 2002, the KSE was the world’s best performing stock market. It has tripled in value since 2008 and even last year it was the fourth, registering an increase of almost 50 per cent behind Venezuela, Turkey and Egypt.

Frontier markets have less liquidity and market capitalisation (only 3 per cent of the global share), so they present significant risk to investors. They tend to grow much faster, just as penny stocks do over large caps as there’s more room on the upside. The problem is they can implode just as quickly and liquidity is harder to find on the way down.

The general recommended risk allocation for emerging markets in a portfolio is 15-20 per cent, while for frontier markets, a 5 per cent portion is advised. Returns have however surpassed what the advocated weightings would suggest, as the Morgan Stanley Capital International (MSCI) emerging market index gained 3 per cent over the last year, while its frontier market index gained 22 per cent.

Rebalancing the frontier markets portion of a portfolio is easier than the lack of liquidity would suggest. If that 5 per cent portfolio portion of frontier market stock loses value, there are plenty of sellers in a bear market to buy from and get the weighting back up. Alternatively, liquidity is ample during a bull run too. Usually an investor would pick one or two frontier markets instead of trying to break up a 5 per cent allocation as well. Pakistan currently has a 4 per cent weighting in the MSCI Index as it has an above average market capitalisation of the 32 countries represented.

To an outside investor Pakistan can look very scary. There are rudimentary economic shortcomings, the most glaring being the energy crisis. It is therefore a remarkable show of faith that more than half a billion dollars of foreign investment has flowed into Pakistan’s capital markets. International portfolio investments have streamed in during the past six months, reflecting a growing appetite for the KSE in particular.

The relative cheapness (to the BSE’s) of the assets suggests there is plenty of room to grow. Add to this the fact that some of Pakistan’s biggest gainers have been among the more highly capitalised shares, encompassing prominent names in banking, cement and oil and gas. KSE however still lacks in liquidity. One may encounter problems getting in and out of positions for the majority of the 570-odd stocks listed. Only about 60 have consistent daily trading volume. One third of all holdings are held by foreign investors. This is an area with room for improvement.

The major Black Swan event of 2013 in Pakistan has likely passed with the market already having made waves and fortunes having been made, but investors have learned that the KSE has a penchant for skyrocketing more often than expected. Even a modest sign of stability for the nation as a whole goes a long way in this stock market.

Transparency measures

There is an asterisk that partly hangs over the KSE’s stellar performance. An amnesty scheme was announced in January 2012 allowing a two-and-a-half-year period during which there would be no due diligence conducted on the source of funds being invested in the stock market. Average daily volume rose from 79 million shares in 2011 to 173 million last year, accounting for the steep rise in total market capitalisation as well. While foreign investment, remittances and institutional participation all played a major role in the KSE’s surge, part of it is attributed to the amnesty programme.

But the implications of money laundering hamper investor confidence. The government has thus taken a step in the right direction, establishing a centralised Know-Your-Customer Agency for registering and maintaining investor records. International practices are to be incorporated and the regulatory framework surrounding Pakistan’s capital markets seems to be strengthening. An overhaul of the Securities and Exchange Commission of Pakistan also transpired with investigations launched to tackle insider trading.■